Financial terms were not disclosed, but a source confirmed to ESPNNewYork.com that the deal is worth $16.5 million.
A restricted free agent, Bailey rebounded from a slow start this past season to finish with 11 goals and eight assists in 38 games. The former first-round pick scored six goals and 10 points over New York's final 13 regular-season games, helping the Islanders reach the playoffs for the first time since 2007.
"Josh has become an important member of the young core of the players we have in our dressing room," Islanders general manager Garth Snow said in a release. "We're excited to come to terms with him on a deal that will ensure he is a member of this team as we solidify ourselves as consistent playoff contenders."
Bailey, 23, has 58 goals and 81 assists in 329 career games with the Islanders, who selected the Ontario native with the ninth overall pick in the 2008 draft.
ESPNNewYork.com's Katie Strang contributed to this report.